Southwest Ventures is considering an investment in an Austin, Texas– based startup firm called Creed and Company. Creed and Company is involved in organic gardening and has developed a complete line of organic products for sale to the public that ranges from composted soils to organic pesticides. The company has been around for almost twenty years and has developed a very good reputation in the Austin business community, as well as with the many organic gardeners who live in the area. Last year, Creed generated earnings before interest, taxes, and depreciation (EBITDA) of $ 4 million. The company needs to raise $ 5.8 million to finance the acquisition of a similar company called Organic and More that operates in both the Houston and Dallas markets. The acquisition would make it possible for Creed to market its private- label products to a much broader customer base in the major metropolitan areas of Texas. Moreover, Organic and More earned EBITDA of $ 1 million in 2015.
The owners of Creed view the acquisition and its funding as a critical element of their business strategy, but they are concerned about how much of the company they will have to give up to a venture capitalist in order to raise the needed funds. Creed hired an experienced financial consultant, whom they trust, to evaluate the prospects of raising the needed funds. The consultant estimated that the company would be valued at a multiple of five times EBITDA in five years and that Creed would grow the combined EBITDAs of the two companies at a rate of 20% per year over the next five years if the acquisition of Organic and More is completed.
Neither Creed nor its acquisition target, Organic and More, uses debt financing at present. However, the VC has offered to provide the acquisition financing in the form of convertible debt that pays interest at a rate of 8% per year and is due and payable in five years.
a. What enterprise value do you estimate for Creed (including the planned acquisition) in five years?
b. If the VC offers to finance the needed funds using convertible debt that pays 8% per year and converts to a share of the company sufficient to provide a 25% rate of return on his investment over the next five years, how much of the firm’s equity will he demand?
c. What fraction of the ownership in Creed would the venture capitalist require if Creed is able to grow its EBITDA by 30% per year (all else remaining the same) and the VC still requires a 25% rate of return over the next five years?